Sunday, February 12, 2012

Some Sins of Textbook Economics

People who are ignorant of economics are
susceptible to all sorts of misunderstandings. Fortunately knowledge of
even just the basics of sound economics is a powerful inoculant against
many dangerous falsehoods and half-truths.
This fact, however,
does not imply that exposure to more economics is necessarily good. The
sad reality is that economists too often present their analyses of
markets in ways that confuse not only unsuspecting non-economists but
also—and too often—economists themselves.
A frequently encountered
instance of this confusion is economists’ discussion of competition.
What introductory economics textbooks describe as “perfect” (or “pure”)
competition resembles nothing that occurs in the real world. In the
world of the textbooks, firms don’t differentiate their products from
those of their rivals. Firms never try to win more customers by
improving the quality of their products. Also, firms don’t advertise.
Indeed they don’t even cut prices because each “perfectly competitive”
firm is a “price taker”: It’s too small to affect the market price and
so can sell as much as it wishes at whatever price prevails in the
market.
These and other problems with the model of “perfect
competition” have been pointed out repeatedly, especially by economists
steeped in the Austrian tradition—see, for example, Hayek’s essay “The
Meaning of Competition.” Yet the typical economist still clings to the
notion that “perfect competition” is perfect competition. This typical
economist, it must be admitted, does understand that the conditions
necessary for “perfect competition” to prevail in actual markets can
never exist. But the model remains the ideal against which real-world
markets are judged. The closer real-world markets appear to be to
textbook “perfectly competitive” markets, the more competitive
real-world markets are assumed to be.
And competition being a good
thing, this typical economist presumes that policies advertised as
moving real-world markets closer to the “perfectly competitive” ideal
are desirable.

Assumed Conclusions

But such a presumption
is unwarranted, in part because many of the conclusions of the analysis
are snuck into the model’s initial assumptions.
Most important
among this model’s foundational assumptions is that competitive forces
play out only in the form of price cuts. Therefore anything that
prevents prices from being cut (down to levels that the model specifies
as appropriate) is regarded as an obstacle to competition—indeed, as an
element of monopoly that prevents the economy from operating more
efficiently.
To this day, many mainstream economists describe any
firm that can raise, even modestly, the price it charges for its product
without driving away all of its customers as possessing some monopoly
power.
Note the confusion: A pest-control producer that aims to
increase its sales by making a better mousetrap is regarded by this
model as behaving monopolistically! Competing for customers by doing
something other than simply cutting prices is, according to the model,
not competitive.
You can’t make this stuff up.
Another
example of how economists commonly confuse themselves (and others)
involves the issue of “market failure.” That same introductory economics
textbook that teaches the model of “perfect competition” explains a few
chapters later that markets perform suboptimally whenever some groups
of people act in ways that affect other groups of people without the
consent of these third parties. The textbook then explains that,
happily, economists know how to design taxes or regulations to fix the
problem.

Externalities and Assumptions

Such
situations—economists call them “externalities”—are indeed bad. If Smith
pays Jones to hit me in the head with a hammer without my consent,
I—the third party—am unquestionably made worse off. (A simple, and best,
solution in this case is to give me an enforceable property right in my
person: No one can hit me and get away with it without my consent.)
But
the stories that economists typically tell of externalities—and of how
to “solve” them—too loosely sneak in illegitimate assumptions.
Here’s
an example: Smith pays Jones for pork chops whose production at Jones’s
pig farm next door to where I live fills my house with obnoxious odors.
The economist leaps to the conclusion that I am wronged. Perhaps I am.
But suppose that I bought my house knowing that it was next door to a
pig farm. Am I still wronged? No: The price I paid for my house was
discounted because of its location within smelling distance of the farm.
Not only have I consented to endure swinish odors in my home, I’ve been
compensated for doing so (in the form of a lower price than that of a
similar home located in a sweeter-smelling neighborhood).
Or
suppose, alternatively, that the pig farm moves into my neighborhood by
surprise, after I buy my house. Now am I harmed? The answer is unclear.
If the location of my house is such that homebuyers should reasonably
expect the possibility that farms might set up shop nearby, then when I
bought my house there was an open question about whether or not
home-owners have the right to odor-free air in the neighborhood. And
because this question cannot be answered by economics alone, it’s
illegitimate for an economist to conclude that the farm necessarily
should be taxed or regulated for the purpose of cleansing the
neighborhood air of stinky odors.

The Largest Externalities

Economists
are correct to point out that externalities exist. But economists are
far too frivolous in going about labeling this or that effect an
“externality”—and, what is even worse, are far too glib in supposing
that government can be trusted to “internalize” externalities in ways
that improve the allocation of resources rather than making it worse.
Don’t
forget what too many economists seem never to grasp: Collective
decision-making itself—from citizens voting to politicians spending
taxpayers’ money—is infected with what are perhaps the largest and most
intractable externalities. Costs are imposed on third parties
constantly.
Economics done properly would highlight the dangers of
trying to cure externalities with a process that itself is deeply
infected with externalities. Unfortunately economics is too often done
improperly.